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Portfolio acquisitions: Valuing intangibles

If your private equity firm is performing the valuation of intangible assets of a portfolio company to satisfy the accounting requirements of ASC 805, our observations, best practices, and examples can help.

Portfolio acquisitions: Valuing intangibles

Does your private equity firm have the experience, expertise, and internal resources necessary to
perform the valuation of intangible assets of a portfolio company? While many of our non-private equity
corporate clients may be involved in only a few transactions over their entire career, our private equity
clients often have several transactions in a single quarter. Due to this extensive expertise, many of them
perform these valuations, satisfying the accounting requirements of Accounting Standards Codification
805 (ASC 805), Business Combinations. The following article provides our observations of best practices
in ASC 805 valuation analyses.

Common intangible assets

The intangible assets most commonly acquired as part of a typical acquisition include: trademarks and
trade names, proprietary (or patented) technology, customer-related intangibles, non-compete
agreements, and workforce in place. Although the workforce in place asset is included as a component
of goodwill on the opening balance sheet, its fair value is determined as it impacts the fair value of the
customer-related intangibles.

When determining the fair value of these intangible assets, it is necessary for our clients to analyze a significant amount of data to support their conclusions.

Some of our clients have elected the Private Company Council (PCC) alternative with regards to ASC 805.
When electing the PCC alternative, the customer-related and non-compete agreement intangible assets
don’t need to be separately recognized from goodwill. Some clients have elected the PCC alternative to
simplify their financial reporting, while many others continue to maintain the status quo and account for
all intangibles as in the past, in order to maintain optimal flexibility and avoid any costly restatements of
financial statements in the event of a future public offering or possible sale to a publicly traded
company.

Critical supporting analyses

Development of an implied internal rate of return

In order to test the overall reasonableness of the fair value of the purchase price relative to the financial
projections and utilized in the ASC 805 analyses, it’s best practice to calculate the internal rate of return
(IRR) that is implied based on the combination of the financial projections and the transaction purchase
price. It’s appropriate to select the discounted cash flow (DCF) method in order to determine the IRR.

The application of the DCF method requires the development of discrete cash flow projections for the
subject company. The determination of the relevant cash flows involves adjusting estimated future
earnings to arrive at debt-free cash flow, which is the cash flow available for all capital holders – both
debt holders and equity holders. Included in these adjustments are anticipated reinvestments required
for future growth, such as working capital and capital expenditures. Most if not all of our private equity
clients have already developed these projections to support the purchase price of the subject company.

An illustration of an IRR analysis is included in Schedule A of the example. The implied IRR should
reconcile with the market participant weighted average cost of capital (“WACC”) calculation, as well are
the weighted average return on assets (“WARA”) calculation – both of which are discussed below.

Development of a weighted average cost of capital

An important part of the discounted cash flow method is the development of a discount rate for use in
determining the present value of the cash flows generated by a market participant. The reasonableness
of the IRR described above should be tested by developing the subject company’s WACC from a market
participant’s view. The WACC represents the weighted average return expectation for a company’s
invested capital or its operating assets, including a normal level of working capital. The development of
an appropriate WACC requires estimates of both an equity rate of return and a debt rate of return.
Thus, the WACC is a function of both the required return on equity/debt and the mix of those
components in the capital structure.

The most common methods for determining the equity rate of return are the capital asset pricing model
or the build-up method. We find that many of our private equity clients utilize the build-up method, an
illustration of which is included in Schedule B of the example >>

Weighted average return on assets

The weighted average return on assets (WARA) analysis reconciles the fair values of the net
assets/liabilities acquired (and the returns assigned to those assets as a part of the ASC 805 analysis)
with the overall return associated with the subject company as a whole. This analysis is typically used as
a reasonableness check to verify that the results of the fair value analyses are reasonable in comparison
to the overall transaction. When the sum of the individual asset weighted returns (i.e., the WARA)
closely matches the IRR and WACC, it helps support the conclusions of fair values. An illustration of the
WARA analysis is included in Schedule C of the example >>

Commonly used methods to value intangible assets

Relief-from-royalty – Trademark/Trade names

This method is commonly utilized to value both trademark/trade name and proprietary (or patented)
technology intangible assets. The relief-from-royalty method is a hybrid form of both the income
approach and the market approach. The premise of the relief-from-royalty method is that the owners of
the company would be compelled to pay the rightful owner of the intangible asset for the right to use it,
if they didn’t already own the intangible asset. Since the legal right to use the intellectual property
relieves ownership from such payments (royalties), the financial condition of the company is enhanced.

In order to measure the payments avoided, an appropriate royalty rate (usually expressed as a
percentage of revenue) is selected based upon publicly available royalty data from third-party license
agreements, relative profitability of the company due to the intangible asset, and management’s
assessment of the overall importance of the intangible asset. A royalty rate implied from this analysis is
then often compared to a “profit split rule of thumb.” This rule of thumb estimates that 20–33 percent
of the licensee’s profits are typically the share to be paid as the royalty to the licensor. However, this
rule of thumb should be utilized as a reasonableness check and never utilized as the primary method for
determining the royalty rate. After determination of an appropriate royalty rate, a stream is developed
for the products or services that utilize the intangible asset to which the royalty rate is applied. Then the
present value of the after-tax royalty savings over the economic useful life of the asset is calculated. An
illustration of the relief-from-royalty method is included in Schedule D of the example >>

Multi-period excess earnings – Customer-related intangibles

The fair value of customer relationships is typically estimated using a variation of the income approach,
specifically the multi-period excess earnings methodology (MPEEM). The MPEEM is based on the
principle that the value of an intangible asset is equal to the present value of the incremental after-tax
economic earnings attributable to that intangible asset. Debt-free future earnings associated with
customer relationships are typically estimated consistent with the IRR supporting analysis. In addition,
the required returns on the other contributory assets employed by the business (e.g., net working
capital (cash-free, debt-free), net fixed assets, assembled workforce, and other identifiable intangible assets) are then deducted from the discounted future earnings. These deductions account for the use
and contribution of other assets employed that are necessary (in addition to the customer relationships)
to achieve the projected excess earnings.

An EBITA margin for the existing customers is developed based upon projection data estimated
by management. Due to differences in levels of selling, marketing, travel and entertainment,
and other expenses among existing customers and attracting new customers, the margin of
existing customers can be incrementally higher than the company as a whole.

After-tax contributory asset charges for the use of the tangible and identified intangible assets.
Examples include net working capital, fixed assets, trademark/trade names, workforce in place,
etc.
•

The present value of the after-tax economic earnings associated with the customer relationships
is calculated using a discount rate that incorporates the increased riskiness of the intangible
asset relative to the company as a whole.

An illustration of the valuation of a customer related intangible asset utilizing the MPEEM
method is included in Schedule E of the example >>

With and without – Non-compete agreements

A technique of the income approach commonly referred to as the “with and without” method is
generally used most often to determine the fair value of the non-compete intangible assets. (However,
it can also be used to determine the fair value of other difficult to value intangible assets.) This method
compares the expected cash flows of the company “with” the non-compete agreement in place to the
expected cash flows of the company “without.” To apply this method, the present values of the
expected cash flows to be derived from the company under each scenario are compared. The “with”
scenario is the same scenario utilized in the IRR analysis and contemplates the revenue and cash flow of
the company with the non-compete agreement in place. The “without” scenario usually alters the
revenue and, consequently, the cash flows, as if there wasn’t a non-compete agreement in place. The
“with and without” cash flows are typically limited to the duration of the non-competition agreement.
The sum of the present value of the difference in cash flows is calculated to determine the raw value of
a non-compete agreement. The raw value is multiplied by an estimate of the likelihood of competition
to arrive at an indicated fair value of the non-compete agreement. An illustration of the “with and
without” method is included in Schedule F of the example >>

Cost approach – Workforce in place/internally developed software

Although ASC Topic 805 states that the value of an assembled workforce acquired in a business
combination should not be recorded separately from goodwill on a company’s opening balance sheet, it
is necessary to estimate the fair value of the workforce asset so that an appropriate contributory asset
charge relating to the workforce in place asset can be applied in the multi-period excess earnings
method used in measuring the fair value of the customer-related intangibles. Significant expenditures
for recruiting, selecting, and training would be required to replace a company’s existing employees. The
inclusion of the fully trained and efficient workforce in a transaction allows a company to avoid the
expenditures that would be required to hire equivalent personnel. The value of the assembled
workforce is typically represented by the sum of costs avoided.

To determine the total costs, employee data as of the date of the transaction is analyzed by
management, including the total number of employees, stratification of employees by job description,
salary, bonus, and benefits. Then cost estimates are developed by management for items such as
training period, training productivity factor (costs associated with employee inefficiency capture the
amount of time inefficiently used by a new employee during the initial training period on the job), and
acquisition costs (interview time, headhunter fees, advertising, etc.). An illustration of this method for
determining the fair value of the workforce in place is included in Schedule G of the example. The cost
approach is also utilized in the valuation of other intangible assets, such as internally developed
software.

Summary

There is no question that the valuation of intangible assets for ASC 805 purposes can be a complex
exercise. However, many of our clients – especially those in the private equity industry – have been able
to develop internal procedures and analyses required to assign fair value measurement to the acquired
intangibles on the opening balance sheet.